Financial Development and the Effects of Volatility on Growth

Abstract This chapter argues, based on Aghino-Angeletos-Banerjee-Manova (AABM), that the presence of credit constraints can help us understand why volatility is so costly for growth. The basic idea behind this explanation is rather obvious: The long-term productivity-enhancing investment in the model developed in the previous chapter creates a need for liquidity; with perfect credit markets the necessary liquidity is always supplied. Not so with imperfect credit markets: The liquidity shock is only financed when the firm has enough profits, because only profitable firms can borrow a lot. A negative productivity shock, by making firms less profitable, makes it less likely that the liquidity need would not be met. As a result, a fraction of the potentially productivity-enhancing long-term investments will go to waste, with obvious consequences for growth.